You are on page 1of 25

chapter eleven

Financial Forces

McGraw-Hill/Irwin
International Business, 11/e Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives

 Explain how money can be made and lost in the


foreign exchange (FX) markets

 Understand foreign exchange quotations, including


cross rates

 Describe currency exchange controls

 Explain how financial forces such as tariffs, taxes,


inflation and the balance of payments can affect
international management

11-3
Fluctuating Currency Values

• Freely floating currencies fluctuate


against each other

• Fluctuations may be quite large

• Financial managers must understand


how to protect against losses or optimize
gains

11-4
Foreign Exchange Terminology

 Foreign Exchange Quotation


 The price of one currency expressed in terms of another
 Reported in the world’s currency exchange markets
 Central reserve asset
 Asset, usually currency, held by a government’s central bank
 Vehicle currency
 A currency used as a vehicle for international trade or investment
 Intervention currency
 A currency used by a country to intervene in the foreign currency
exchange markets, often to buy (strengthen) its own currency

11-5
Foreign Exchange Quotations

 Exchange Rates
 Foreign currency X’s per US$ rate can be computed
from the reciprocal of the US$ equivalent rate of
currency X (and vice versa)

(1) / (US$ equivalent rate of currency X) =


= (Currency X per US$ rate)

(1) / (Currency X per US$ rate) =


= (US$ equivalent rate of currency X)

11-6
Exchange Rate for June 19 and June 16,
2006

11-7
Exchange Rates

 Spot rates
 The exchange rate between two currencies
for delivery within two business days
 Forward currency market
 Trading market for currency contracts
deliverable 30, 60, 90, or 180 days in the
future
 Forward rate
 The exchange rate between two currencies
for delivery in the future, usually 30, 60, 90,
or 180 days
11-8
Exchange Rates

 Trading at a premium
 A currency’s forward rate quote is stronger than
the spot rate
 Trading at a discount
 A currency’s forward rate quotes is weaker than
the spot rate
 Premium or a discount depends on the
expectations of the world financial community,
businesses, individuals, and governments
about what the future will bring
11-9
Exchange Rates

 Cross Rates
 Currency exchange rates for trading directly
between non-U.S. dollar currencies
 Bid price
 Price offered to buy
 Ask price
 Sales price

11-10
Influences of Exchange Rate Fluctuation

 Supply and demand of the currency

 Interest rates

 Inflation

 Expectations

11-11
Exchange Rate Fluctuation

• Monetary policies
– Government policies that control the amount of
money in circulation and its growth rate
• Fiscal policies
– Policies that address the collecting and spending of
money by the government
• Law of one price
– Concept that in an efficient market, like products
will have like prices
• Arbitrage
– The process of buying and selling instantaneously
to make profit with no risk

11-12
Exchange Rate Fluctuation

• Fisher effect
– The relationship between real and nominal interest
rates: the real interest rate will be the nominal
interest rate minus the expected rate of inflation
• International Fisher effect
– Concept that the interest rate differentials for any
two currencies will reflect the expected change in
their exchange rates
• Purchasing Power Parity (PPP)
– Theory that predicts that currency exchange rates
between two countries should equal the ratio of the
price levels of their commodity baskets
11-13
Exchange Rate Forecasting

 Efficient market approach


 Assumption that current market prices fully
reflect all available relevant information
 Random walk hypothesis
 Assumption that the unpredictability of
factors suggests that the best predictor of
tomorrow’s prices is today’s prices

11-14
Exchange Rate Forecasting

 Fundamental approach
 Exchange rate prediction based on
econometric models that attempt to capture
the variables and their correct relationships
 Technical analysis
 An approach that analyzes data for trends
and then projects these trends forward

11-15
Currency Exchange Controls

 Government controls that limit the legal uses


of a currency in international transactions
 Value of currency is arbitrarily fixed at a rate
higher than its market value
 If you see “official rate” next to a currency rate
quotation, that country has currency exchange
controls in place

11-16
Currency Exchange Controls

 A black market typically surfaces as a


result of currency exchange controls
 However, this type of currency exchange
transaction is illegal
 The black market is rarely able to
accommodate transactions of the size
involved in international business

11-17
Tariffs

• Tariffs
– Taxes, usually on imported goods
– May be ad valorem, specific, compound, or
variable

11-18
Taxation

 Income tax
• Direct tax on personal and corporate income
 Value-added tax (VAT)
• A tax charged on the value added to a good as it
moves through production from raw materials to
final purchaser
 Withholding tax
• Indirect tax levied on passive income that the
corporation would pay out to non residents

11-19
Corporate Tax Rates

11-20
Inflation

• A trend of rising prices


– May be caused by demand exceeding
supply
– May be caused by an increase in the money
supply
• Measured by consumer price index (CPI)
– Basket of consumer goods
• Gross domestic product deflator--OECD
– Takes into account the prices of
intermediate goods and services
11-21
GDP Deflator. Average annual growth in
percentage, 1991-2004

11-22
Inflation and the International Company

 High inflation rates

 Make capital expenditure planning more


difficult
 Cause the cost of goods and services to rise
 Tend to cause BOP deficits
 Could lead to more restrictive fiscal or
monetary policies, currency controls, export
incentives, and import obstacles

11-23
Inflation and the International Company

 High inflation rates

 Encourage borrowing because the loan will be repaid


with cheaper money

 Bring high interest rates

 Discourage lending

 Make capital expenditure planning more difficult


11-24
Balance of Payments (BOP)

 The state of a nation’s BOP reveals the state


of that country’s economy
 If the BOP is slipping into deficit
 the government is probably considering one or
more market or nonmarket measures to correct or
suppress that deficit
Currency devaluation or restrictive
monetary or fiscal policies to induce
deflation are likely
Currency or trade controls may be near
11-25

You might also like